What Net Present Value Can’t Tell You

Investing 10 million dollars in a program that will return 20 million dollars in 3 years with 100% certainty…or

Investing 1 million dollars in a program that will return 3 million dollars in 3 years with 50% certainty?

Basic theory says the first option is more valuable. I can expect to accrue 10 million in profit on an initial investment of 10 million. In the second scenario, if I can find 10 similar investments, I can expect to receive 5 million in profit — since I am losing the principle on half of my investments. Even absent the runaway administrative costs that are pervasive in so many corporate organizations, it’s easy to see that 10 million is greater than 5 million, so as a corporate finance executive, that’s where I’ll place my bet.

Easy, right?

Unfortunately, it’s potentially too easy. In the above example, the only information I’ve provided is information about the potential outcomes for the investor in the first three years of an investment’s performance. The truth is that most programs don’t simply up and disappear after three years. And the longer they can impact your organization, the more difficult it is for people to project their exact financials with any sort of certainty. If I told you that the million-dollar investment was the experiment that led to the Kindle at Amazon, or the iPod at Apple, you’d likely think twice about suggesting that Option A was the more valuable — even though it might look that way in a simple spreadsheet.

Instead of comparing the above projects with a simple 3-year net present value calculation (all too common in corporate America), more executives need to think of project investments as complex options. A small, uncertain, investment can give us the option on extreme upside, while often a larger, more certain, investment might give us no option value at all. And instead of the simple financial tools we’re handed in college courses in corporate finance, when we’re valuing projects based on the option value they confer – we need to be very careful to match the valuation methodology to the opportunity. Complex options require a more complex way of thinking about the investment in front of us.

Another Take

Many of us intuitively understand complex options. Consider young students deciding to track towards surgery in the United States. It’s a long, hard road, costing hundreds of thousands of dollars and taking as long as 15 years. But when students evaluate the opportunity, they consider what they could achieve when they finish and what they need to do to leave the option to surgery — the highest-paying specialty — open. With their time, money, and psyche, they invest, knowing the only way to miss out entirely is by not investing in their options at all.

Venture capitalists pursue investments in much the same fashion. In an interview with New York Magazine, Marc Andreesen recently suggested that the most important question a venture capitalist can ask is, “What if it works?” The best VCs don’t invest in the company today, or the projected cash flows they’ll receive in 5 years. They look at a young entrepreneur and ask, “If we set out down this path, how large can this business become? How transformational will its technology and information be if it’s successful? How many industries will this impact?”

Just like the surgeon that sets out to go to college and study biology as a first step towards something bigger, the best Venture Capitalists ensure that both they and their entrepreneurs are leaving their options open to capture the biggest gains at every step of the way.

Inside large corporations we make investment decisions differently. Instead of buying options on some sort of transformational opportunity, most executives invest only in the next logical step. We typically see folks concentrate on measures like ROI, IRR, and, in the best case, projected cash flows. Each a measure that holds its investor captive to the construct of an excel spreadsheet.

While these types of tools can be extremely valuable for incremental change, they do very little to help us peer out into the future and make large strategic bets. They help us optimize which turbine to purchase or which geographic area to approach next. But when it comes to transforming the organization, combating disruption, or the creating new growth businesses, these measures fall flat. Their horizons are too short.

Large companies everywhere would be benefited by asking themselves three questions:

What if it works? To understand the value of an option, investors need to be able to think through the possible outcomes. No outcome is more important in the case of innovation than the success of the project. If it works, what can you accomplish? Only once you have a sense for how much upside exists in the option and how likely it is to occur, can you actually start comparing it to the other investment opportunities in front of you.

What’s required to leave the option open to upside? The second question is about minimizing downside. Many companies falter here. They might see the option for upside, but then overcommit. Instead of investing to get to the next step — to learn whether or not it’s worthwhile to invest in the stage afterwards — executives often commit to everything all at once. They make public announcements to much fanfare that results in either wasted capital or embarrassing backstepping if the option doesn’t pay off.

Do we have what it takes to follow this through? In the public markets, we can sell options without executing them. Inside our organizations, an option is only valuable if we can follow it through. IBM Research, Bell Labs, and Xerox Parc each provided their parent with options on breakthrough technologies. Now even worse than simply fumbling the opportunity provided (as was the case with much of what was invented in those venerated halls), is investing in an option without a plan or capability to follow it through. That’s simply wasted cash.

So when you set out to transform the way you invest in long term growth opportunities, make sure to ask yourself, if this is a wild success, “do we have what it takes to keep investing in its growth?” Will culture permit it? Will your investment process accomodate? Will your public market investors understand?

Investment decisions are always complicated. But over simplifying them only leads to trouble. Instead of forcing everything you do onto a single page DCF in Excel, ask yourself “What if it works?” the next time something truly inspirational comes across your desk. Then make sure you leave open the option for upside.

Maxwell Wessel is the general manager of SAP.iO, a lecturer at Stanford’s Graduate School of Business, and an investor with Nextgen Venture Partners. Connect with him on twitter @maxwellelliot